After the brief “correction” in October, the market basically pulled a Men In Black where it essentially looked at the pen and proceeded to forget the past and resumed its ascendency to record highs. I made a couple of moves on my portfolios to bank some profits and to open some new positions. This is despite my feelings that the stock market is still overpriced.

This is my second foray into Southwest Airlines. I bought into Southwest in August 2016 and I was able to generate a return of 25.9 percent. The stock has been tracking down the last few weeks so I decided to take a look again and see if there was an opportunity to jump back in. Even though I’ve analyzed the company, I still ask the same 8 questions about the company. Many of my responses are similar to a few years ago so I am not going to reinvent the wheel, but where I needed to refresh the evaluation was on the numbers side, specifically the financial performance and valuation. Here are my responses.

Question 1: What do they sell?

As always we go to our good friends at Reuters with their cheat note definition of Southwest.

“Southwest Airlines Co. (Southwest) operates Southwest Airlines. Southwest is a passenger airline that provides scheduled air transportation in the United States and near-international markets. The Company serves approximately 100 destinations in over 40 states, such as the District of Columbia, the Commonwealth of Puerto Rico, and approximately seven near-international countries, including Mexico, Jamaica, The Bahamas, Aruba, Dominican Republic, Costa Rica, and Belize. The Company added its first three destinations in Central America (San Jose, Costa Rica, Belize City, Belize, and Liberia, Costa Rica) and also commenced Southwest service to a fourth destination in Mexico (Puerto Vallarta). Southwest operates a total of approximately 704 Boeing 737 aircraft. The Company also added approximately 20 domestic nonstop destinations from Dallas Love Field. Southwest offers a total of 180 weekday departures to 50 nonstop destinations from Dallas Love Field.”

Southwest sells one of the core day-to-day needs which is transportation. They sell mobility, more specifically regional mobility. Before Southwest, airline travel was all about experience and amenities. Southwest came in a said, flying is really about utility and getting from point A to point B so it should be no different from taking a bus or a train. You get on board, the plane takes off and lands. You get off and move on. To achieve this Southwest had to streamline it’s business processes. Specifically Southwest pioneered some interesting functions in the airline game:

They use only one type of plane, the Boeing 737, which saves the company millions in maintenance costs and other operating costs. Pilots only have to be familiar with one type of plane so training costs are lower.

Focus on point-to-point direct flights instead of traditional hub and spoke formats which reduces filght delays and risks of missing connecting flights. Their on-time performance has consistently among the highest in the industry.

They don’t offer tiered/class level service like fancy drinks, meals, slippers. Everyone gets the same level of service. Doing so again reduces costs for the airline to clean and restock their planes.

They’re pretty upfront with their prices. Hidden fees are kept to a miniumum or are non-existant at all.

The airline is unionized yet there has never been a strike in the company’s history. Customer service is a religion and it starts with the culture that empowers employees to take ownership of the solution and issues instead of relying on a bureaucracy.

Question 2: Who do they compete with?

Southwest while still considering themselves a “regional” airline competes pretty hard against other national US airlines like United and Delta along with other discount carriers like JetBlue.

Question 3: Who buys their products and services?

Travelling is core need for everyone. As with offering a discount value proposition, their core clientele tends to be smaller businesses that have tight budgets but rely on transportation to secure needed business in other parts of the country.

Question 4: Will they buy their product over and over again?

As long as there is required need for people to travel and travel cheaply, there will be a need for airlines.

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Question 5: Do they make money?

Source: Valuentum Securities

Southwest continues to generate strong Economic Profit. Over the past 3 years, the company’s return on invested capital has come in the 19 to 25 percent range which is much higher than its cost of capital which is approximately 10 percent. Revenues have been growing modestly in the 4 percent range which is inline with the industry. The company has now generated 48 straight quarters of profit, which is amazing.

Questions 6: What do they own and who do they own money to?

Southwest’s financial position is still quite strong. In fact I think it’s in a stronger financial position than it was a few years ago. It’s under any financial threat. While the company’s ratio of current assets to current liabilities is low, the company has a high liquidity level with more cash in the bank than debt. It is generating enough cash to cover its day-to-day operations. Their debt level is very manageable and quite low for a capital intensive business. Their debt/equity ratio comes in at 0.25 which is pretty manageable. If interest rates continue to track up in the future, Southwest should be able to manage through it. The company has very little intangible assets to the quality of the company’s assets is very high. Out of all airline company’s, Southwest is financially the strongest.

Question 7: How risky is the business?

SAME AS PREVIOUS The company faces similar risks, specifically the cyclicality of the economy and input costs such as jet fuel and labour costs. The company has benefitted over the past few years from very low oil prices. Technology has also enabled

Question 8: Is the stock cheap?

Source: Valuentum Securities

The stock has had a pretty strong run and at one point it reached in the mid-$70’s. It has since been slowly falling back to earth. In terms of valuation the stock on a relative basis is still on the pricey side. On a discounted cash flow basis the intrinsic value comes in the $50 to mid-$60’s range, so the stock, even after the recent pullback is appears to be fairly valued. In reality the stock has always been expensive to own, but when you are generating the type of consistent financial performance like they have, you will have to pay a premium, which makes sense. The odds of being able to buy shares at ½ prices are pretty low.

The Decision

Southwest continues to be a best of breed company in the airline space. It really hasn’t missed a step since I last bought in a few years ago. The stock is still relatively expensive right now but given the nervousness of the markets lately I thought it may be a good time to buy a small position right now and buy more shares if it should continue to fall. The management team continues to generate consistent wealth for its shareholders. It is still a high quality business and so I’m happy to buy back into Southwest. I bought in at $55.